A practical guide for farmers MAKING FINANCIAL DECISIONS How to choose the best financial solutions for your agricultural business
ABOUT THE BROCHURE About the brochure This brochure was developed to assist small and medium-sized Ukrainian farmers with choosing financial products that best suit their specific business needs. If you are planning to invest in agricultural equipment or inputs, this brochure will provide you with guidance on how to: analyse and choose financial products that match your investment plan compare the terms and conditions of financial products choose the best available offer determine how much debt is too much debt avoid cash flow problems increase competitiveness while saving on energy costs Table of contents I. Four steps to financial decision-making...p. 4 Step 1: Decide how to finance your investment plan...p. 5 Step 2: Estimate your capacity to finance your investment plan...p. 10 Step 3: Select conditions that match your investment plan...p.13 Step 4: Define the repayment schedule according to your cash flow...p. 18 II. Feature: Energy efficiency investments...p. 20 III. Decision-making flowchart...p. 25 IV. Checklist: Don t forget to ask...p. 26 V. Case studies... p. 9, 11, 20, 22 Disclaimer Imprint Published by EFSE Development Facility and Independent Association of the Banks of Ukraine (NABU); Concept, layout and lithography: IPC and EFSE Development Facility 2016 EFSE Development Facility Information contained in this document has been checked by EFSE DF with due diligence. However, EFSE DF does not assume any liability or guarantee for the timeliness, accuracy, and completeness of the information provided herein. EFSE DF reserves the right to change or amend the information provided at any time and without prior notice. EFSE DF makes no warranties, express or implied, as to the suitability of this document for a particular purpose or application. This document does not necessarily address every important topic or cover every aspect of the topics. The information in this document does not constitute investment, legal, tax or any other advice. It has been prepared without regard to the individual financial and other circumstances of persons who read it. 2
INTRODUCTION Farming and agricultural business: How to find the best financing solutions Most farmers would agree that it is very difficult to run an agricultural business without credit. There always seems to be a need for more funding, whether it is for inputs or equipment. But how much debt can your business take on? The first step towards answering this question is to assess your specific situation, starting with calculating your cash flows the money flowing into and out of your business. Definition Cash flow is the movement or flow of money into and out of a business. cash flows into the business as finished products are sold at the market Inflow Outflow cash flows out of the business to purchase inputs, such as seeds and fer tilisers, and to pay expenses Farm 3
FOUR STEPS TO FINANCIAL DECISION-MAKING Four steps to financial decision-making The starting point for making good financing decisions is always the analysis of your business s financial situation and needs. Whether you are engaged in grain production, dairy farming or any other type of agricultural activity, the process of analysing your business s needs is the same. First, you need to determine which type of investment you would like to finance. Second, you should make sure that you have the capacity to support the amount of debt you want to take on. Third, you need to choose financial solutions that match your business needs. This includes choosing a financial product with an appropriate maturity at an acceptable cost. Fourth, you should select conditions, e.g. repayment schedules that match your cash flow to ensure that you will be able to comfortably repay your loan. This means that the currency of the loan should ideally match the currency of your incoming cash flow and that the proposed repayment plan of the loan should schedule payments in the months when you will have funds available to cover them. By following these steps, you can weigh the advantages and disadvantages of different financial products to arrive at a financial decision that matches your business and helps it to grow and prosper. Step 1: Decide how to finance your investment plan Step 2: Estimate your capacity to finance your investment plan Step 3: Select conditions that match your investment plan Step 4: Define the repayment schedule according to your cash flow 4
STEP 1: DETERMINE THE TYPE OF INVESTMENT Step 1: Decide how to finance your investment plan What kind of investment do I want to make? What kind of loan or credit do I need? Like most businesses, agricultural businesses need both operating inputs (seeds, pesticides, fuel, worker salaries) and fixed assets (tractors, crop storage facilities) to run. The type of loan you take will largely depend on the type of investment you would like to make in your business. There are two main options for financing: working capital loans (including supplier credit) and fixed asset loans. Working capital loans: These loans are used to purchase inputs such as seeds, pesticides and fertilisers, as well as to cover any other immediate operational costs, such as the purchase of fuel or the payment of workers salaries, for example. Fixed asset loans: These loans are used to purchase equipment, such as ploughs, combine harvesters or tractors, and also for other long-term assets, such as warehouses and silos, or any other type of asset you will use for production over several years. Mixed purpose loans: As their name suggests, these loans can be used for both fixed assets and working capital needs. Example of a balance sheet for a small-scale farmer In the balance sheet below, you can see the working capital and fixed assets in the left (Assets) column. On the right you can see the short-term debts, which are generally working capital loans (<12 months maturity), and the long-term debts, which are generally for fixed assets and have maturities longer than one year. Assets Working capital 2,660,120 Short-term debt ( 12 months) Liabilities 875,400 Cash 50,000 Debt to input suppliers 518,400 Stock of inputs (seeds, fertilisers and pesticides) 1,640,600 Short-term facilities from financial institutions 357,000 Crops in the field 969,520 Other short-term debts 0 Fixed assets 2,334,500 Buildings 300,000 Tractors, combines and other equipment Long-term debt (>12 months) Long-term loans from financial institutions 110,000 110,000 2,034,500 Debt to leasing companies 0 Other long-term debts 0 Total liabilities 985,400 Equity 4,009,220 Total assets 4,994,620 Total liabilities and equity 4,994,620 All values in UAH 5
STEP 1: DECIDE HOW TO FINANCE YOUR INVESTMENT PLAN The first question to ask yourself is: Do I want to increase my working capital or do I want to invest in fixed assets? I need working capital Whether you need working capital for inputs or for other costs of operating your farm, such as paying salaries or purchasing fuel, you can find a number of institutions in Ukraine that offer short-term financing to farmers. There are two main options available: 1. obtain inputs from your suppliers on supplier credit 2. take out a working capital loan from a financial institution to pay suppliers and cover other expenses Other less common options for financing working capital needs include promissory notes, overdrafts, and loans from private sources. Which option best suits your needs? Financing option 1: Supplier credit As you know, suppliers sell both on credit and on an upfront cash basis. If you need inputs but do not have the cash flow on hand, you could obtain them on credit from your supplier. Pros of using supplier credit: The procedure is simple, resulting in a quick or instant decision For recurring clients, no collateral is usually required Some suppliers offer additional benefits, such as free delivery of inputs or agronomic support Cons of using supplier credit: It is usually more expensive to purchase goods on supplier credit than to pay for them upfront in cash The price of inputs is very often indexed to a foreign currency, which creates FX risks for the farmer Typically only a limited range of inputs are available for purchase with supplier credit The term for repayment is relatively short, i.e. due shortly after the harvest 6
STEP 1: DECIDE HOW TO FINANCE YOUR INVESTMENT PLAN Financing option 2: Working capital loan from a financial institution Suppliers generally give discounts of up to 20-30% for upfront cash purchases, depending on factors such as the brand and quality of the inputs, supplier pricing strategy and the client s relationship with the supplier. Therefore, depending on the offer from your input supplier and your relationship with your financial institution, it could be more advantageous for you to take a loan to purchase inputs upfront in cash and take advantage of the discounted price from your supplier. You can also use a working capital loan if you need to pay for items or services that you cannot purchase with supplier credit. Loan maturities usually range from one production cycle up to 12 months, the loans can be obtained in hryvnas without being indexed to a foreign currency, and interest rates are fixed for the duration of the loan. Pros of using a working capital loan: They can be used to make upfront cash payments to input suppliers, resulting in discounted prices The funds can be used for additional working capital needs, such as paying salaries, purchasing fuel, or renting machinery Loans are generally cheaper than supplier credit Most of the loans are disbursed in UAH, thus creating no FX risk to the business The maturity is relatively long, which allows flexibility in terms of when you sell your harvest Cons of using a working capital loan: Collateral is required The loan amount may not cover the full cost of a production cycle Processing times are longer (i.e. there is no instant approval) Other options for financing working capital needs: Promissory notes Promissory note is a financial instrument that allows the payee to request from the issuer the repayment of a specified amount of debt at a specified time. One may ask a question: who will agree to lend to an unknown person and who secures the repayment of the loan on time? In order to assure the repayment promissory notes are availed by banks that can assess creditworthiness of the issuer. When availed, the bank becomes a guarantor for the issuer. This financial instrument is gradually becoming popular among farmers due to the low costs (bank's fee for availing - 4-6% interest per year) and simple issuing procedures. Suppliers are also willing to accept promissory notes from farmers in exchange for agricultural inputs. Please check if your bank offers this product and carefully review the terms and conditions. Overdrafts If you maintain a certain level of transactions via your bank account, then your bank may offer you an overdraft. With an overdraft, you can finance your short-term needs even if your account balance falls to zero. While the maturity of an overdraft is generally 30 days, some financial institutions may offer longer periods of up to 90 days. The overdraft amount is set individually and your bank may request collateral. Please consider that your bank will charge interest and a fee for the overdraft. Private loans It is relatively quick and easy to obtain a private loan as private lenders do not require a multitude of documents and sometimes do not even require collateral. Despite these advantages, please consider that a private loan could end up being the most expensive option. For example, interest rates of 3, 4, and 5% per month add up to 36, 48, and 60% per year, respectively. Moreover, please ensure that your loan repayment schedule is documented on paper and that you will be able to meet the payments with your future cash flows. Last but not least, make sure that the loan currency will be fixed and not indexed to another currency; otherwise, you will incur FX risks and the cost of the loan can increase significantly. 7
STEP 1: DECIDE HOW TO FINANCE YOUR INVESTMENT PLAN I want to invest in fixed assets Fixed assets are the backbone of an agricultural business: Having them and keeping them in good condition has a direct impact on your production cycle. However, investments in fixed assets tend to be costly and their payback periods run well over 12 months; therefore, you would need to have access to large amounts of long-term funds. The most common way to invest in fixed assets is to take a loan from a financial institution. In some cases, it is useful to check whether your equipment or machinery supplier has leasing options or partnership programmes with any of the banks or leasing companies. Many of these programmes offer special conditions which usually aim at lowering the final cost of your loan transaction or accelerating the loan approval process. You may also ask your bank representative if the bank participates in any partnership programmes with suppliers. Loan from a financial institution With a long-term bank loan you can finance the purchase of agricultural equipment and machinery, such as tractors, combine harvesters, ploughs or other multi-stage equipment, or the construction of facilities, such as silos or warehouses. Depending on the scale of your business, you can make several investments at once. Pros of financing from a financial institution: Maturities are longer from 3 to 7 years The loan can be used to purchase used equipment or new equipment The loan will finance a large part of your investment plan in some cases even up to 100% Repayment schedules are more flexible, with payments matching your cash flow and grace periods on capital repayment, i.e. repayments can be scheduled for post-harvest periods Banks collateral policies tend to be flexible; some lenders accept personal assets as well as business assets All of your income is taken into account, e.g. private income or income from other businesses as well as agricultural business income Cons of financing from a financial institution: The processing time can be several weeks or more There are additional costs and fees obligatory insurance, administration fees to consider Bankable collateral and/or additional guarantees may be requested 8
STEP 1: DECIDE HOW TO FINANCE YOUR INVESTMENT PLAN So, should I take supplier credit or a working capital loan? Other options for financing investments in fixed assets: Leasing One of the ways to purchase equipment such as tractors, combine harvesters or other farming implements is via dedicated leasing companies. Leasing companies have direct relationships with equipment suppliers and are a convenient option if your investment plan only involves purchasing equipment. Of course, you should always compare leasing costs with other means of financing, i.e. bank loans. How does a leasing operation work? 1. Choose a seller of the equipment that suits your needs 5. Start using the equipment and make timely leasing payments 3. After making an initial instalment for your equipment, the leasing company pays the full amount to the seller you leasing company 4. Leasing company insures the equipment 2. Negotiate leasing conditions (instalments, maturity) and conclude an agreement with a leasing company Partnership programmes Some financial institutions and equipment suppliers have jointly established special programmes to simplify certain procedures for farmers in obtaining long-term loans to buy specific equipment. When taking part in such programmes, you may benefit from simple and quick procedures, or if programme criteria are satisfied, receive funds at a reduced or subsidised rate. Please ask your bank representative or equipment supplier if they offer such programmes. Case study: Supplier credit vs. working capital loan Mr. Kravchenko needs to purchase UAH 500,000 worth of inputs. His supplier offers him a 20% discount if he agrees to pay upfront in cash. He can get a loan to purchase the inputs but must pay 24% in interest per year in interest plus processing fees. Does it make sense to take the loan to pay for the inputs upfront and get the discount, or should he obtain the inputs on credit from his supplier? Financing option 1: Purchase on supplier credit Cost of inputs purchased on supplier credit: UAH 500,000 Financing option 2: Take out a working capital loan Cost of inputs purchased in cash with a 20% discount: UAH 400,000 Loan details: Amount UAH 400,000 Interest rate 24% per year Interest monthly payment UAH 8,000 Fees 2% of principal amount (UAH 8,000) Maturity 8 months Example of cash flow of a working capital loan Feb Mar April May June July Aug Sept disbursement fee & monthly interest 16,000 monthly interest 8,000 monthly interest 8,000 monthly interest 8,000 monthly interest 8,000 monthly interest 8,000 monthly interest 8,000 capital repayment & monthly interest 408,000 Conclusion In this case, the total cost of the inputs if purchased on supplier credit is UAH 500,000, while as the table above shows, the total cost of the inputs purchased upfront in cash with a loan adds up to UAH 472,000. Purchasing the inputs with a loan therefore saves Mr. Kravchenko UAH 28,000. 9
STEP 2: ESTIMATE YOUR CAPACITY TO FINANCE YOUR INVESTMENT PLAN Step 2: Estimate your capacity to finance your investment plan The next step in financial decision-making is determining your business s limits in terms of repayment and debt capacity. Lenders have limits on how much they can lend to a single client and usually determine the maximum amount by calculating the client s equity ratio. This ratio reflects how much of the business is financed with funds contributed by the owner(s). Definition Equity is the sum of the value of all your assets minus all of your debts, both formal and informal, including debts to suppliers or private individuals. Rule of thumb If you are planning a large investment for expanding your business, it is very important that you are able to determine whether the investment is within your maximum debt capacity, which is the maximum amount of debt that you can afford to have at one time, regardless of the size of the instalments. A rule of thumb is that the equity ratio should not be below 30%. Therefore, you should estimate your current equity ratio as well as make sure that your equity ratio will not fall below 30% when you take on additional debt for a new investment. What is my equity ratio, and what does it tell me? The equity ratio reflects how much of your assets are financed by your own funds. It is calculated by dividing your equity by your total assets. If the equity ratio falls to zero or becomes negative, this means that your equity is zero or negative and that the business has debts equal to or greater than the business s total assets. If the debt is too high and the equity ratio is too low, the business will eventually cease to be economically viable and go bankrupt. 30% 10
STEP 2: ESTIMATE YOUR CAPACITY TO FINANCE YOUR INVESTMENT PLAN Case study: Equity ratio calculation Mr. Bondar farms 1,500 ha. He sees two investment opportunities, but first he has to determine his debt capacity by putting together a balance sheet of his current assets and liabilities: Assets Liabilities Working capital 5,842,000 Short-term debts 5,015,000 Cash 100,000 Stock of inputs (seeds, fertilisers and pesticides) 3,609,000 Crops in the field 2,133,000 Debt to input suppliers Short-term facilities from financial institutions Other short-term debts 2,015,000 3,000,000 0 Good to know Fair valuation of assets In order to determine the value of your assets for the purpose of calculating your equity ratio, it is important to consider the fair value of your assets, or, in other words, a realistic price for which you could expect to sell the assets in the local second-hand market. A good method for determining the fair value of a piece of equipment is by comparing the prices of similar equipment for sale in the second-hand market. Fixed assets 5,823,000 Long-term debt 2,485,000 Tractors and lorries 2,343,000 Implements 545,000 Combine harvesters 2,935,000 Loan for combine harvester 2,485,000 Total assets 11,665,000 Total liabilities 7,500,000 Equity 4,165,000 = - Based on the balance sheet, he must then calculate his current equity and his equity ratio: Total assets 11,665,000 All values in UAH Total liabilities and equity 11,665,000 Equity UAH 4,165,000 Total assets UAH 11,665,000 = 36% current equity ratio 11
STEP 2: ESTIMATE YOUR CAPACITY TO FINANCE YOUR INVESTMENT PLAN Current investment plan Mr. Bondar is interested in building a grain silo (UAH 1,900,000) and starting a dairy operation (UAH 3,500,000), and he would like to finance both projects with a loan of UAH 5,400,000. In order to calculate his expected equity ratio after the investment is made, Mr. Bondar must adjust his balance sheet to reflect both the assets (the new grain silo and all assets related to the dairy operation) and the loan: Assets Liabilities Working capital 5,842,000 Short-term debts 5,015,000 Cash 100,000 Stock of inputs (seeds, fertilisers and pesticides) 3,609,000 Debt to input suppliers Short-term facilities from financial institutions 2,015,000 3,000,000 Crops in the field 2,133,000 Other short-term debts 0 Fixed assets 11,223,000 Long-term debt 7,885,000 Tractors and lorries 2,343,000 Implements 545,000 Grain storage 1,900,000 Loan for investment Dairy equipment & plan 3,500,000 livestock Combine harvesters 2,935,000 Loan for combine harvester 5,400,000 2,485,000 Total liabilities 12,900,000 The amount of equity remains the same because no funds would be contributed to the project by the owner. However, the expected equity ratio would change to 24%. Since the original investment plan put the expected equity ratio below 30%, Mr. Alexandru must adjust his investment plan so that it is an amount of credit his business can currently support. Adjusted investment plan In order to reduce the cost of his investment plan, Mr. Bondar decides to build the silo for UAH 1,900,000 and postpone the dairy operation. To adjust his balance sheet, he adds UAH 1,900,000 to his fixed assets and UAH 1,900,000 to his long-term liabilities in his current estimated balance sheet. The adjustment leads to total assets of UAH 13,565,000, total liabilities of UAH 9,400,000 and equity of UAH 4,165,000. Mr. Bondar s calculation: Total assets UAH 13,565,000 Total liabilities UAH 9,400,000 = Equity UAH 4,165,000 Equity UAH 4,165,000 Total assets UAH 13,565,000 = 31% expected equity ratio Equity 4,165,000 Total assets 17,065,000 All values in UAH Equity UAH 4,165,000 Total assets UAH 17,065,000 Total liabilities and equity = 17,065,000 24% expected equity ratio When the investment plan is altered, the equity ratio remains at an acceptable level. 12
STEP 3: SELECT CONDITIONS THAT MATCH YOUR INVESTMENT PLAN Step 3: Select conditions that match your investment plan Now that you have determined which financial product suits your investment and have established that you have the capacity to repay the loan amount, it is time to request offers from potential lenders and apply for a loan. To be able to make an informed decision, you will need to compare the conditions of the products offered, namely: loan maturity interest rate cost of borrowing. Definition A revolving facility is a loan that is renewed regularly, each season or annually, assuming that the borrower has repaid on time and that the business s condition is stable. A revolving facility assumes faster approval process of your future loans as most of the procedures are put through at the initial stage. Working capital loans The maturity of your loan will depend on the type of investment you are making. Working capital loan facilities are short-term by definition, ranging from one crop cycle up to one year. Most lenders offer revolving loans or credit lines for working capital. Fixed asset loans Investment loans are generally long-term loans. Long-term loans are more appropriate for investments in fixed assets because the cost of the asset is usually large in comparison to the profit the asset generates, but the asset will generate profit for many years. Mixed purpose loans Mixed purpose loans are usually for an investment plan that includes both working capital and investment in fixed assets. Not all financial institutions offer them. Instead of a single mixed purpose loan, some institutions may offer you two separate loans: a working capital facility and an investment loan. The institutions that do provide mixed purpose loans usually offer a maximum maturity of three or four years. If you need working capital and want to make an investment at the same time, explain this to your financial institution and ask about your options for either receiving a mixed purpose facility or combining different loan products. 13
STEP 3: SELECT CONDITIONS THAT MATCH YOUR INVESTMENT PLAN Maturities: How do I match the maturity with my investment plan? Business opportunities sometimes come up at very short notice and require a quick decision. For example, let s say you have a chance to buy a used harvester at a good price. However, you only have a short time to pay the seller before he sells the harvester to another buyer. When opportunities like this arise, you need money fast but don t always have time to wait for the bank to approve a loan. So you pay for the investment with the money you already have, usually taking it from your working capital. But wait: Aren t you then actually financing the machinery, a fixed asset, with a working capital loan facility? Shouldn t you allow yourself a longer period of time to pay for this investment? The situation described above is what lenders call depletion of working capital, which simply means you have used your working capital for longer-term investments. This is a problem because working capital funds are the funds that need to circulate in your business, transforming from inputs into crops, into cash and back into inputs to replant. So if you deplete your working capital, you may not have enough funds available to plant your next crop. This is a problem for both you as a farmer and your financial institution because it puts stress on your business when you finance long-term investments with short-term funds. If this occurs, it is better to consult with your financial institution about options to avoid refinancing the investment with short-term facilities. A longer-term investment loan to reimburse the funds you took from your working capital or a permanent working capital loan would be more appropriate to top up your working capital and ensure that you do not run into refinancing problems in the future. Attention: Try to match the maturity of the investment with the maturity of the financing. For working capital loans, the maturity should correspond with the planting cycle that the funds are used for, and for investment in fixed assets, the maturity should correspond to the expected useful life of the asset. 14
STEP 3: SELECT CONDITIONS THAT MATCH YOUR INVESTMENT PLAN Example of a balance sheet with unbalanced liabilities In this balance sheet example, the business has significantly higher short-term liabilities than working capital (short-term) assets. The farmer has taken out several short-term loans to finance the purchase of fixed assets. If the short-term facilities expire without being renewed, the farmer will have a problem finding enough cash to finance the next crop. In addition, the farmer faces the risk that interest rates for future credits could be higher than in the past, which in turn would increase the overall cost of financing the purchase of the fixed assets. Example of a balance sheet with balanced liabilities In this example, the farmer has balanced short- and long-term assets with short- and long-term liabilities. The total amount of debt (UAH 1,710,000) and equity ratio (40%) are the same, but the farmer is now in a better position because it is no longer necessary to depend as heavily on the renewal of short-term loans to finance the business. working capital shor t- term debt working capital shor t- term debt Assets (at fair value) Liabilities Assets (at fair value) Liabilities Working capital 1,086,000 Short-term debt 1,330,000 Cash 30,000 Debt to input suppliers 480,000 Working capital 1,086,000 Short-term debt 780,000 Cash 30,000 Debt to input suppliers 480,000 Stock of inputs 110,000 Short-term facilities from financial institutions 850,000 Stock of inputs 110,000 Short-term facilities from financial institutions 300,000 Crops in the field 946,000 Other short-term debts 0 Fixed assets 1,770,000 Long-term debt 380,000 Crops in the field 946,000 Other short-term debts 0 Fixed assets 1,770,000 Long-term debt 930,000 Buildings 150,000 Long-term loans from financial institutions 0 Buildings 150,000 Long-term loans from financial institutions 550,000 Tractors, combines and other equipment 1,620,000 Debts to leasing companies 380,000 Tractors, combines and other equipment 1,620,000 Debts to leasing companies 380,000 Other long-term debts Other long-term debts Total liabilities 1,710,000 Equity 1,146,000 Total assets 2,856,000 Total liabilities & equity 2,856,000 All values in UAH Total liabilities 1,710,000 Equity 1,146,000 Total assets 2,856,000 Total liabilities & equity 2,856,000 All values in UAH 15
STEP 3: SELECT CONDITIONS THAT MATCH YOUR INVESTMENT PLAN Understanding interest rates When a financial institution sets an interest rate, it takes into consideration its cost of funding plus a premium to allow for the risk that you will not be able to repay your loan. This risk is due to several factors: the overall economic situation, the situation of the agricultural sector and your individual risk. When the financial institution assesses your individual risk, it generally looks at the financial stability of your business (i.e. length of time in operation, profitability, liquidity), your credit history, the quality of your collateral and the collateral s personal importance to you, along with your relationship with the institution. The more stable your business is, the stronger your credit history is, the more valuable and important your collateral is to you, and the better your relationship with the financial institution is, the lower the interest rate offer should be. Effective cost of borrowing: Three key factors to bear in mind T ip 1: When comparing two offers, compare the effective interest rate or the effective cost of borrowing, rather than the nominal interest rate. Attention: Foreign exchange (FX) risks Imagine you decide to take a private loan denominated in (or indexed to) a foreign currency. When you decide to take a loan such as this, you run an FX risk if your business earnings are denominated in a different currency than the loan. If your business revenues are generated in UAH, but the currency of the loan gains in value against the UAH, your loan repayments will become more expensive and will eat up your revenues. The FX risk is not a one-time occurrence; it will remain in effect for the duration of your loan. When taking out a loan in foreign currency, consider this risk and estimate whether you will earn enough revenues in that foreign currency to mitigate this risk. If the answer is No, ask for a loan in local currency only. Lenders typically quote their nominal annual interest rates. However, the nominal interest rate does not include all of the costs related to the loan. These other costs, such as management fees or organisational fees, can vary significantly from lender to lender and increase the real cost of loans by 1.5% to 4.5%. The nominal interest rate plus all other costs related to a loan charged by the financial institution is called the effective interest rate. Usually, but not always, all of the charges related to the loan can be found in the repayment schedule or can be requested from the financial institution. Besides the fees charged by the financial institution, there may be other obligatory costs, such as insurance, which also need to be taken into consideration. The sum of the expenses payable to the financial institution and any additional expenses is called the effective cost of borrowing. 16
STEP 3: SELECT CONDITIONS THAT MATCH YOUR INVESTMENT PLAN T ip 2: Choose a repayment schedule that minimises your effective cost of borrowing. T ip 3: Plan ahead: Allow enough time to find the right source of financing. Another factor that has an especially large impact on the total effective cost of borrowing for farmers is the repayment schedule. Since farm income is irregular, the instalments of agricultural loans are usually also irregular, with payments due only one to four times a year. For the same amount, maturity and effective interest rate, a loan with a yearly instalment will have a higher effective cost of borrowing than a loan with two or more instalments, such as a bi-annual repayment schedule. Although it may be necessary to choose a seasonal repayment schedule because it matches your cash flow, it is important to understand that the effective costs of borrowing will be higher. When faced with the decision to choose between different repayment schedules, you should choose more frequent repayments to reduce the effective cost of borrowing. To clearly see the impact of the repayment schedule on the effective cost of borrowing, you can calculate the total interest and charges appearing in the repayment schedule provided by the financial institution. The business environment may change unpredictably, just like the weather; however, you can at least roughly plan the time it will take to obtain a loan for your investments or working capital needs. This usually varies between 4-7 weeks, depending on the purpose of the loan, and the larger the loan amount, the more time will be needed. Other types of financial instruments may require less time, i.e. up to 4 weeks, but they might be more expensive. Please also consider that getting a loan requires a dual effort: the client has to provide a complete list of required documents and financial information, while the bank has to analyse the client s information. One way to speed up the process is to have all or most of the required documents ready for submission. Note that some financial institutions offer up to 6 months of validity after the loan is approved, meaning that you have up to 6 months after the approval of the loan to actually use the funds, which gives you more flexibility in terms of timing your investment. 17
STEP 4: DEFINE THE REPAYMENT SCHEDULE ACCORDING TO YOUR CASH FLOW Step 4: Define repayment schedule according to your cash flow After you have agreed to a loan amount and interest rate, you are usually presented with a repayment schedule. When checking whether a repayment schedule is right for you, the most important thing is that it corresponds to your expected cash flow. There are three aspects you especially need to pay attention to when it comes to your business s cash flow: Scheduling of payments Payments must be planned for time periods when you have inflows into your business. This might seem like a no-brainer, but if financial institutions do not understand your activity well, they may give you a generic monthly, bi-monthly or quarterly repayment schedule based on the assumption that during the periods between payments you will have some income you can save to pay the loan at the end of the term. However, a financial institution that knows your activity well will make an effort to properly forecast and plan your instalments in accordance with your cash flow so as to ensure that the repayment plan is convenient for you and that you do not have problems repaying the loan. 18
STEP 4: DEFINE THE REPAYMENT SCHEDULE ACCORDING TO YOUR CASH FLOW Instalment amount Besides ensuring that the payments are scheduled for the right time, it is also important to make sure that you can afford to pay the amount of the instalment. This means that you know you will have sufficient funds after selling your crop to repay all short-term debts, plant the next crop and finally repay any additional loans you may have. If you take a long-term loan with a maturity of more than 3 years, you should ensure that you will have additional funds after all repayments. You will need these additional funds because other investment needs will come up in 4 or 5 years time. Currency The loan and repayments should be denominated in the same currency as your inflows/income. Some people think that just because they need to pay for their new tractor in euros that they have to take out a loan in euros, even though they always receive payments for their crops in hryvna. This is not the case, however: You can take out a loan in the same currency as your income, convert it into euros at today s exchange rate, pay for the tractor and repay the loan with the hryvnas you earn. This way you will avoid possible losses from fluctuations in the exchange rate. 19
FEATURE: ENERGY EFFICIENCY INVESTMENTS Energy efficiency: Save energy, save money As your farm grows larger, greater efficiency and lower production costs will become increasingly important. There are several ways to improve efficiency on your farm, such as better inputs and technology to increase yields. One of the major trends in global agriculture that is catching on in Ukraine is to invest in new farming technologies and techniques that minimise fuel and input consumption. The ultimate goal of energy efficiency investments is to reduce the amount of energy required to produce the same amount of a product. The savings from reduced fuel consumption pay for the investment and reduce costs in the long term. Energy efficiency investments include, for example, tractors and combine harvesters with efficient fuel consumption as well as multi-stage or one-pass farm equipment. Definition Multi-stage or one-pass farm equipment is equipment that can be used for multiple field preparation steps. The equipment is fuel efficient because it reduces the number of times the tractor must pass over the field by performing multiple steps in just one pass, for example seeding and applying fertiliser at the same time. Case study: Multi-stage equipment Mr. Melnichenko has 800 hectares of wheat fields. He wants to introduce multi-stage equipment in order to increase productivity and lower fuel consumption. Mr. Melnichenko previously had to pass over his fields four times: with a mouldboard (20 cm), chisel plough, disk harrow and seeder. His total fuel consumption was 60 litres of diesel per hectare or about UAH 800,000 per year at current diesel prices. He has chosen to invest UAH 1,400,000 in a piece of multistage equipment that combines 3 steps of soil preparation: sub-soiler, chisel plough and disc plough. Now, during soil before: 60 litres of diesel per hectare Attention: Multi-stage equipment is a large investment, usually starting at UAH 1,400,000 or more. Based on current prices, the fuel savings to be gained by using multi-stage equipment justifies the investment cost for land holdings of 800 hectares or more. 20
FEATURE: ENERGY EFFICIENCY INVESTMENTS preparation the tractor only passes over the field twice: once with the (heavier) multi-stage equipment and another time with the seeder. This requires 35 litres of diesel per hectare or roughly UAH 465,000 at current diesel prices. The total annual savings in fuel costs is about UAH 313,000.Considering the cost of the multi-stage equipment (UAH 1,400,000) and the annual savings (UAH 313,000), the fuel savings pay for the investment in approximately 4.5 years. Additionally, the farmer saves time because fewer passes must be made over the field. Calculation: Field preparation Total conventional tillage fuel consumption, L/ha Total minimum tillage fuel consumption, L/ha Conventional tillage 58.4 - Use of one-pass equipment - 34.9 Area of the farm, ha 800. Total fuel consumption, L 46,720 27,920 Av. diesel price 2014 incl. subsidy, in UAH/L 16.67. Annual energy costs, in UAH 778,822 465,426 Annual energy savings, in UAH - 313,396 x = x x = = - = Investment costs, in UAH - 1,400,000 : 313,396 Payback period of equipment, in years - 4.5 after: 35 litres of diesel per hectare Good to know Other benefits of multi-stage equipment More efficient equipment can have additional benefits besides saving fuel, such as more precise application of fertiliser and seeds, which saves inputs and increases yields. For detailed information on additional benefits, consult a trustworthy equipment supplier. 21
CASE STUDY: A NEW TRACTOR AND GRAIN SILO Case study: A new tractor and grain silo Mr. Lazarchuk has been in business for 15 years and currently runs his private farm on 840 hectares (he farms 50 ha and rents the remaining 790 ha). He currently cultivates corn, wheat, sunflowers and barley. Step 1: Decide how to finance your investment plan Mr. Lazarchuk is looking for a way to finance a two-part plan to invest in fixed assets. First, he would like to purchase a tractor for UAH 760,000. Second, he would like to build a 1,000 tonne grain silo in which to store part of his crops. He has an offer to build a silo for a total cost of UAH 350,000. Therefore, to complete the investment plan, he needs financing of UAH 1,110,000. He enquired at two different financial institutions about a loan for UAH 1,110,000 in order to compare the offers: Offer from financial institution #1 20%, maturity of 5 years; 1% disbursement commission. Interest is repaid monthly, principal is repaid after the harvest (August-December of every season). Collateral requirement: Agricultural machinery, real estate or other liquid assets. Repayment information Effective interest rate: 21% Monthly instalment amount (first year): - during grace period: UAH 18,500 - in other periods: UAH 60,000-63,000 Offer from financial institution #2 Overall effective cost of borrowing: UAH 640,100 22%, maturity of 5 years; 1.5% disbursement commission. Interest is repaid monthly, principal is repaid once a year (December). Collateral requirement: Agricultural machinery, real estate or other liquid assets. Repayment information Effective interest rate: 23.5% Monthly instalment amount (first year): - during grace period: UAH 20,350 - in December: UAH 242,350 Overall effective cost of borrowing: UAH 749,250 22
CASE STUDY: A NEW TRACTOR AND GRAIN SILO Step 2: Estimate your capacity to finance your investment plan Now that Mr. Lazarchuk has decided on a concrete investment plan, he must check his equity ratio to test whether his business can support the debt. Estimated balance sheet Mr. Lazarchuk has already estimated his current balance sheet based on his accounting information and his own estimates. First he calculates his current equity ratio from his estimated balance sheet: Now he must calculate his expected equity ratio assuming he takes out a loan of UAH 1,110,000. To do this he takes the total assets from his balance sheet and adds the value of the investment (UAH 1,110,000) to the fixed asset sections under: - buildings, grain silo (since the investment will be in a grain silo) - tractors, combines and other equipment (since the investment will be in a tractor) to reach a new total assets figure of UAH 7,260,000. Then he must also add the corresponding liability of UAH 1,110,000 to the long-term loans from financial institutions since it has a maturity of >12 months, which leads to a new total liabilities figure of UAH 3,760,000. Expected balance sheet Now that he has adjusted his balance sheet, he can calculate the expected equity ratio: Assets (at fair value) Liabilities Assets (at fair value) Liabilities Working capital 3,070,000 Short-term debt 1,770,000 Cash 200,000 Debt to input suppliers 620,000 Working capital 3,070,000 Short-term debt 1,770,000 Cash 200,000 Debt to input suppliers 620,000 Stock of inputs (seeds, fertilisers and pesticides) 420,000 Short-term facilities from financial institutions 1,150,000 Stock of inputs (seeds, fertilisers and pesticides) 420,000 Short-term facilities from financial institutions 1,150,000 Crops in the field 2,450,000 Other short-term debts 0 Fixed assets 3,230,000 Long-term debt 880,000 Crops in the field 2,450,000 Other short-term debts 0 Fixed assets 4,340,000 Long-term debt 1,990,000 Buildings 330,000 Long-term loans from financial institutions 650,000 Buildings, grain storage 680,000 Long-term loans from financial institutions 1,760,000 Tractors, combines and other equipment 2,900,000 Debts to leasing companies 230,000 Tractors, combines and other equipment 3,660,000 Debts to leasing companies 230,000 Other long-term debts 0 Total liabilities 2,650,000 Equity 3,650,000 Total assets 6,300,000 Total liabilities & equity 6,300,000 Other long-term debts 0 Total liabilities 3,760,000 Equity 3,650,000 Total assets 7,410,000 Total liabilities & equity 7,410,000 All values in UAH All values in UAH Equity UAH 3,650,000 58% Total assets UAH 6,300,000 = equity ratio Equity UAH 3,650,000 well above the recommended 30% Total assets UAH 7,410,000 = threshold 49% equity ratio still comfor tably above the 30% threshold. 23
CASE STUDY: A NEW TRACTOR AND GRAIN SILO Step 3: Select conditions that match your investment plan Let s consider those two offers again. Interest rate, maturity and effective cost of borrowing: At 21%, the effective interest rate offered by institution #1 is slightly better than the 23.5% interest rate offered by institution #2. After analysing the offers and the effective cost of borrowing they represent, Mr. Lazarchuk realises that the repayment schedule is more important than the difference in the effective costs of borrowing offered by the financial institutions. Financial institution #2 offers a more convenient repayment plan, which allows him to postpone crop selling to the period during which he can obtain peak price. To double check that the five-year maturity matches his balance sheet structure, Mr. Lazarchuk looks at the balance sheet projection he made in step 2. His short-term debts (UAH 1,770,000) do not exceed his working capital (UAH 2,920,000), and his longterm debts (UAH 1,990,000) are also much lower than the value of his total fixed assets (UAH 4,340,000). Since neither the shortterm nor the long-term assets and liabilities are unbalanced, Mr. Lazarchuk is confident that he will not have refinancing problems. After speaking with both financial institutions, he decides that he has a preference for financial institution #2. Although financial institution #1 offers a slightly better interest rate, institution #2 is offering him a more convenient repayment schedule. The price of wheat is UAH 400 per tonne higher in December than in August. To pay off the principal he has to sell 90-100 tonnes of wheat per season, which means that the repayment plan proposed by institution #2 allows him to save UAH 36,000-40,000 every year or UAH 180,000-200,000 for the entire period of the loan. Step 4: Define the repayment schedule according to your cash flow In step 4, Mr. Lazarchuk needs to make sure that the repayment schedule matches his cash inflows. Repayment schedule: Mr. Lazarchuk knows that the prices for agricultural output are lowest during the harvesting period, so he is satisfied with the proposed repayment schedule, because it would allow him to wait until he can obtain a higher price for his crops. Final result: A loan from financial institution #2 for UAH 1,110,000 with an interest rate of 22%, a maturity of 5 years and a 1.5% disbursement commission. Effective interest rate: 23.5%. Monthly interest repayment and principal repayment in December of every year of the loan. Overall effective cost of borrowing: UAH 749,250. Collateral: fixed assets. 24
DECISION-MAKING FLOWCHART Flowchar t for sound financial decision-making Step 1: Determine the type of investment you would like to make Are you interested in working capital, fixed assets or both? Which institutions offer financing for the type of investment you would like to make? Which financial product best fits your investment plan? Step 2: Estimate your capacity to finance your investment plan You should double check that your business can comfortably borrow this amount without running into difficulties. A good rule of thumb is that you should maintain an equity ratio above 30% at all times. Step 3: Select conditions that match your investment plan Make sure that your financial institution offers you an appropriate product for your investment. Remember that the maturity of your financing should match the maturity of your investment. Negotiate with your financial institution to finance fixed asset investment with longer-term financing at affordable rates to ensure that you do not run into liquidity problems in the future. Step 4: Define repayment schedule according to your cash flow Verify that your repayment schedule matches your cash flow. Be sure that you have the capacity to repay the amount. A good rule of thumb is to only accept a loan with a repayment schedule that corresponds with the time and currency of your cash inflows. Additionally, in your own projections, make sure that you have extra funds available for future unexpected needs or investments after you have paid all your debts. 25
CHECKLIST Don t forget to ask Finally, we believe that your financial institution should not only offer you loans, but should also provide you with responsible and transparent advice. Below you will find a checklist of important questions that you should ask yourself about your financial institution before making your decision. Does my financial institution offer several specialised products for agricultural finance? Can representatives clearly explain the specific purpose, advantages and costs of the different products they offer? What criteria does the financial institution apply when assessing whether I can use a specific financial product? Does it consider my financial situation, collateral and/or relationship with the institution? Does the financial institution make an in-depth assessment of my business or only look at my financial statements? Which financial products does my business qualify for? Are there other special financial products that are affordable and could be beneficial for my business, such as guarantee funds or additional insurance? What are the total effective costs of borrowing for each of the offers received? Are there other fees or expenses that I must pay, such as obligatory insurance? Do I have enough information to make a comparison and informed choice between the different offers? Does the maturity offered match the maturity of my investment and allow me enough time to comfortably repay the loan? Does my financial institution offer me repayment schedule options that match my cash flow? Is my financial institution flexible with repayment in the event of harvest problems or natural disasters? How does my financial institution s offer compare to other financial institutions offers or supplier credit? Have I explored all of the possible financing options to complete my investment plan and compared offers from different financial institutions and/or input suppliers? 26